Accounting for IFIs

8/18/2019 Accounting for IFIs

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Accounting for IFIs


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Islamic accounting can be defined as the accounting process which provides

appropriate information (not necessarily limited to financial data) tostakeholders of an entity which will enable them to ensure that the entity is

continuously operating within the bounds of the Islamic Shariah and

delivering on its socio-economic objectives.

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“the process of identifying, measuring and communicating economic andother relevant information, inspired by the Islamic worldview and ethics,

and complied with the Shari’ah (Islamic law) – in order to permit informed

judgments and decisions by potential and expected users of information– to

enhance social welfare and seek the blessings of Allah”. Islamic accounting

is also a tool, which enables Muslims to evaluate their own accountabilitiesto God (in respect of inter-human/environmental transactions).


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Differences between Islamic Accounting and

Conventional Accounting

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Islamic Worldview of Accounting and Accountants

The Islamic worldview of accounting are not merely derived from culturaland philosophical elements aided by science, but one whose original

source is revelation, affirmed by intellectual and intuitive principles.

Islam literally means ‘peace’ and ‘obedience’, and the adherents to Islam

have to be ‘obedient’ to God and to appreciate the purpose of their

existence in this world.

In Islam, accounting should function not only as a service activity

providing financial information to the users and to the public at large but

more importantly accountants should discharge their accountability by

providing information to enable society to follow God’s commandments.


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In terms of responsibility, the accountant in Islam is not merely responsible

to human superiors, the management/client or shareholders.

He/ she is a servant and trustee of God in all situations, is simultaneously

responsible to God the Owner of his very self and the resources he is

utilizing and managing.

To forget or to neglect this fundamental aspect of this responsibility is

tantamount to a betrayal of divine trust with all the attending consequencesin this world and in the hereafter.

The accountant in Islam is motivated to provide work and excellent service

because as a holder of amanah (trustee of God) on earth he must search for

the bounties of God.


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His/ Her work is a form of amal salih (virtuous deed) which is then the key

for the attainment of blessings (true success in this world and in the

hereafter).

His/her work is also a form of ibadah (servitude to God) in so far as it is in

conformity with the divine norms and values.

The accountant who is imbued with the world-view of tawhid (oneness of

God) is not anti-profit or anti-worldly gain within the limits provided byreligion.

His vision of success and failure however extends beyond worldly existence

to the life in

the hereafter.


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Objective of Financial Accounting and Reporting for IFIs

The following are the objectives of financial accounting and reporting for IFIsas given by AAOIFI. To provide:

i. Information about the Islamic bank’s compliance with the Shari’ah

and its objectives and information establishing the separation of prohibited

earnings and expenditures, if any, which occurred, and the manner in

which these were disposed off.

ii. Information about the Islamic bank’s economic resources and related

obligations to assist the users in: evaluating the adequacy of the Islamic

bank’s capital to absorb losses and business risks; assessing the risk

inherent in its investments and; evaluating the degree of liquidity of itsassets and the liquidity requirements for meeting its other obligations.


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iii. Information to assist the concerned party in the determination of Zakat on

the Islamic bank’s funds and the purpose for which it will be disbursed.

iv. Information to assist in estimating cash flows that might be realized from

dealing with the Islamic bank, the timing of those flows and the riskassociated with their realization. The information should be directed

principally at assisting the user in evaluating the Islamic bank’s ability to

generate income and to convert it into cash flows and the adequacy of those

cash flows for distributing profit to equity and investment account holders.

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The Need for Islamic Accounting Standards

The need for accounting records as means for trust building is emphasized in

the Quran

: “... Never get bored with recording it, however small or large, up to its

maturity date, for this is seen by Allah as closer to justice, more supportive to

testimony, and more resolving to doubt, except when it is spot trade carried

out amongst yourselves, then you are not to blame for not recoding it”,(Baqara: 282).

Even for spot transactions where debt is not involved, the Quran allows an

open discretion for taking records, and that is all what accounting is about.


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Islamic accounting practice takes place within the IFIs such as Islamic banks

and Zakat institutions, and it is essential to the running of these institutions.

Islamic accounting practice does not indicate that Islam mandate any particularform of accounting.

However, the manifestation of Islamic faith simply implies that there are

particular forms of accounting to suit the needs of Islamic religious

requirements.

This is particularly true in the context of accounting practices in IFIs. The

prohibition of interest (riba’) and the different forms of financing has led to

modified accounting treatments and disclosure requirements for Islamic

financial services.

This is manifested by the explanations and discussions of accounting for

various Islamic financial services and transactions.


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The discussions of a unique Islamic financial system of Zakat , indicates

the needs for accounting for Zakat . This is especially crucial considering

Zakat is a religious institution that involves quite a number of accounting

implications.

First, it is widely accepted that the primary objective of accounting is to provide useful information to assist users in making economic decisions.

Thus, it can be argued that accounting is therefore, a religious obligation.Hence, if accounting is a religious obligation, then the rules of

accountability must be purely divine. In order to do so, appropriate

accounting framework based on Shariah principles must be in place.

The motivation for the development of Islamic accounting comes together

with the emergence Islamic economic and Islamic resurgence for the last

two to three decades.

The awareness for the need for Islamic accounting is due to basic building

blocks of conventional accounting itself since the International Financial

Reporting Standards (IFRS) are based on interest-based elements.


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This is one of the elements embedded in the conventional accounting

which is already violating the requirements of Shariah.

It is necessary to have Islamic accounting to be in place rather thanconventional accounting in order to provide information on financial

success in Islamic organisations.

The Accounting and Auditing Organisation for IFIs (AAOIFI) was

formed for this reason.


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Second, Islamic accounting may be more appropriate to achieve thesocio-economic and religions objectives of Islamic institutions and

Muslim users.

This is because Islamic institutions such as Islamic banks etc. are

established to meet the socio-economic objectives of the Shariah (Islamic

Law) through the implementation of an Islamic economic system.

Hence, these institutions should logically use Islamic accounting,

especially for monitoring these institutions to achieve their objectives.

However, if conventional accounting which developed to meet the needs

of a capitalist economy is used instead in these institutions, a problem is

likely to occur, which will lead to the institutions not meeting theirShariah socio-economic objectives and even worse may turn these Islamic

institutions into capitalist institutions by providing materialist profit-

focused information instead of the holistic information provided by

Islamic accounting.


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Nevertheless, Islam is not against profit motive that is reasonable. There is

no doubt, therefore, that Islamic accounting would result in an ethical

based accounting system which measures not only profits but social,environmental and religious performance.

Third, with the resurgence of Islam globally, the awareness for the needof Islamic accounting arises.

Islamic accounting as a whole is able to serve the whole gamut of

stakeholders. Its principles do not serve the interest of any particular

group, but to the society as a whole which can make corporations

accountable for their actions and ensure they comply with Shariah

principles.


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Fourth, Islam as a religion embraces a comprehensive system ofhuman conduct, influencing all aspects of life.

The uniqueness of Islam lies in its practicalities. Islam as a religion is

not merely a belief but is a complete way of life.

In fact, accounting is embodied in Islam. This can analogically be seen

from Islamic faith whereby for every human, 2 angels accompanied

them at right and left shoulders, record every good deeds and sins (the

double-entry bookkeeping principles?).

Further, the accounting profession has been mentioned comprehensively

in Quranic verses, portrayed to shoulder responsibility of social and

economic justice.


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. Allah has declared in Quran;

“O ye who believe! When ye deal with each other, in transactions

involving future obligations in a fixed period of time, reduce them to

writing, let a scribe (accountant ?) write down faithfully as between the parties; let not the scribe refuse to write; as Allah has taught him, so let

him write. Let him who incurs the liability dictate, but let fear his Lord

Allah, and not diminish aught of what he owes. If the party liable is

mentally deficient, or weak or unable himself to dictate, let his guardian

dictate faithfully. And get two witnesses, out of your own men, and if thereare not two men, then a man and two woman, such as ye choose, for

witnesses, so that if one of them errs, the other can remind him/ her. The

witnesses should not refuse when they are called on (for evidence).

Disdain not to reduce to writing (your contract) for a future period,

whether it be small and more convenient to prevent doubts among

yourselves but if it be a transaction which ye carry out on the spot among

yourselves there is no blame on you if ye reduce it not to writing. But

neither take witnesses whenever ye make a commercial contract; and let

neither scribe nor witness suffer harm. If ye do (such harm), it would be

wickedness in you. So fear Allah; for it is Allah that teaches you. And

Allah is well acquainted with all things” ( Al-Baqarah, 2: 282).


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Fifth, the proper development of Islamic accounting practice especially inIFIs requires a well regulated Islamic financial service, and one of the key

elements of regulation is accounting regulation.

Therefore, a well-regulated Islamic financial industry requires a sound

accounting and reporting requirements that, first, would meet the

requirements of Shari’ah, and, second, will be relevant to be practiced in

our time.

The need for a codified Islamic accounting primarily stemmed from the

need that Islamic accounting objectives, concepts and principles developed

based on Shari’ah requirements.

However, the Islamic accounting regulation also needs to adapt to themodern accounting regulatory environment to make it relevant to be

practiced in our time.


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The Development of Islamic Accounting Standards

Organization for Islamic Financial Institutions (AAOIFI) was established on1 Safar, 1410H corresponding to 26 February, 1990 in Algiers, and then,

registered on 11 Ramadan 1411 corresponding to 27 March, 1991 in the

State of Bahrain, as an international autonomous not-for-profit Islamic

corporate body that prepares standards for IFIs, through the support of

institutional members (200 members from 45 countries, so far) including

central banks, Islamic financial institutions, and other participants from the

international Islamic banking and finance industry, worldwide


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AAOFI issues accounting, auditing, governance, ethics and Shari'a standards

for Islamic financial institutions and the industry.

AAOIFI has gained assuring support for the implementation of its standards,which are now adopted in the Kingdom of Bahrain, Dubai International

Financial Centre, Jordan, Lebanon, Qatar, Sudan and Syria.

The relevant authorities in Australia, Indonesia, Malaysia, Pakistan, Kingdom

of Saudi Arabia, and South Africa have issued guidelines that are based onAAOIFI’s standards and pronouncements.

In the meantime, the globalisation agenda and international harmonisation

movement of Islamic accounting and financial reporting is gaining momentum.

However, the calls for worldwide adherence to IFRSs to achieve harmonization

in financial reporting regardless of cultural differences should not go

unchallenged.


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Standards that have been developed by AAOIFI as at 30th

September, 2012 are as follows:

Accounting standards 1. Objective of financial accounting for Islamic banks and financial institution

(IFIs).

2. Concept of financial accounting for IFIs.

3. General presentation and disclosure in the financial statements of IFIs.

4. Murabaha and Murabaha to the purchase orderer.

5. Mudaraba financing.6. Musharaka financing.

7. Disclosure of bases for profit allocation between owners’ equity and investment

account holders.

8. Equity of investment account holders and their equivalent.

9. Salam and Parallel Salam.

10. Ijarah and Ijarah Muntahia Bittamleek.

11. Zakah.

12. Istisna’a and Parallel Istisna’a.

13. Provisions and Reserves.

14. General Presentation and Disclosure in the Financial Statements of Islamic

Insurance Companies.


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15. Disclosure of Bases for Determining and Allocating Surplus or Deficit in

Islamic Insurance Companies.

16. Investment Funds.

17. Provisions and Reserves in Islamic Insurance Companies.RSA I),%-0/ K>,,%/&? T,2/42&')/4 2/. I),%-0/ "+%,2')/A

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Auditing Standards

1. Objective and principles of auditing.

2. The Auditor’s Report.

3. Terms of Audit Engagement.

4. Testing for Compliance with Shari’a Rulesand Principles by an External Auditor.

5. The Auditor’s Responsibility to Consider

Fraud and Error in an Audit of Financial

Statements.

Governance Standards 1. Shari’a Supervisory Board: Appointment,

Composition and Report.

2. Shari’a Review.

3. Internal Shari’a Review.

4. Audit and Governance Committee for IFIs.

5. Independence of Shari’a Supervisory Board.

6. Statement on Governance Principles for IFIs.

7. Corporate Social Responsibility.


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Ethics Standards

1. Code of ethics for accountants and auditors of IFIs.

2. Code of ethics for employees of IFIs.

Shari’a Standards

1. Trading in currencies.2. Debit Card, Charge Card and Credit Card

3. Default in Payment by a Debtor.

4. Settlement of Debt by Set-Off.

5. Guarantees.

6. Conversion of a Conventional Bank to an Islamic Bank.

7. Hawala.

8. Murabaha to the Purchase Orderer.

9. Ijarah and Ijarah Muntahia Bittamleek.

10. Salam and Parallel Salam.

11. Istisna’a and Parallel Istisna’a.

12. Sharika (Musharaka) and Modern Corporations.

13. Mudaraba.

14. Documentary Credit.

15. Jua’la.

16. Commercial Papers.

17. Investment Sukuk.

18. Possession (Qabd).19. Loan (Qard).


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Application of GAAPs in Conventional Accounting

Compared with Islamic Accounting

Going Concern Concept:

Basically, the going concern concept embedded in conventional

accounting is not in conflict with the requirements of Islamic

accounting whereby the directors should make assessment on the

firms’ ability to continue as a going concern.

Consequently, the financial statements must also be prepared on the

basis of going concern basis unless the directors want to liquidate the

firms or to cease trading. In Islamic jurisprudence, there is a

presumption of continuity, or istishab.

The presumption of continuity means retaining any event or verdict

experienced in the past until evidence is found that this event or verdict

has changed. Hence if a person is known to exist, his existence is not

denied until there is evidence to the contrary.


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Extending this principle to a business entity, it may be acceptable to

assume that the entity would continue in operation in the foreseeable future

unless and until there is indication that its ability to continue as a goingconcern has ceased, for example, an entity based on Mudharabah which

was meant to be in operation only to the end of the agreed Mudharabah

period.


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Accruals/Matching Concept:

The accruals concept is not in conflict to the requirements of Shariah. Thus,

it is allowable for example, in the case of Murabahah or bay’ bithaman-ajil (BBA) transactions conducted by Islamic banks.

If the banks treat a Murabahah or BBA transaction as a financing

transaction or purely as a sales transaction, it has the same effect on profit.

However, Islamic banks may differ in terms of the timing of recognition ofthe margin: at time of sale, as cash received or as payment becomes due.

From the Islamic perspective, the matching principle which allocates

expenses to their related revenues provides fairness and justice

simultaneously to the shareholders and other stakeholders.


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The Concept of Prudence/Conservatism:

The preparers of financial statements do, however, have to contend with

the uncertainties that inevitably surround many events and circumstances,

such as the collectability of doubtful receivables, the probable useful life

of plant and equipment and the number of warranty claims that may occur.

Such uncertainties are recognized by the disclosure of their nature and

extent and by the exercise of prudence in the preparation of the financialstatements.

Prudence is the inclusion of a degree of caution in the exercise of the

judgements needed in making the estimates required under conditions of

uncertainty such that assets or income are not overstated and liabilities orexpenses are not understated.


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However, the exercise of prudence in Islamic Accounting does not

allow, for example, the creation of hidden reserves or excessive

provisions, the deliberate understatement of assets or income, or the

deliberate overstatement of liabilities or expenses, because the financial

statements would not be neutral, and therefore not have the quality of

reliability.


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The Concept of ‘Substance over Form’:

AAOIFI does not particularly endorse the concept of ‘substance over form’.

In view of the primacy of contract in transactions in Islam, the emergingreality must be constructed or appear to be as the form.

This is evident in the treatment of leased assets ( Ijarah) and sales based

transactions ( Murabahah). For Murabahah contracts, the essence of the

transaction is in fact a sales transactions.

Thus, the ownership title will be passed to the purchaser upon acquisition.

However, the financier or the bank can require the purchaser to pledge the

assets acquired as collateral to the financing amount.

The financier or the bank is prohibited to buy back the assets from the purchaser.


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Consistency Concept:

The requirement for consistency is not in conflict with the Islamic

accounting requirement whereby the presentation and classification ofitems in the financial statements should be retained from one period to the

next unless circumstances require it to change.


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Historical Cost Concept:

The conventional accounting measurement is based on the cost principle that

considers the acquisition cost or historical cost as appropriate measurement basis.

However, this principle is questionable from the Islamic point of view due to its

conflicts with the concept of fairness and justice.

In case of Zakat determination, majority of scholars recommend the use of

current prices on the due date of Zakat . The argument for the use of current

market value has been based on the needs for the most accurate valuation ofwealth to be subjected for Zakat in order to serve justice to both the Zakat

recipients and Zakat payers.

Adherence to the conventional accounting cost principles may lead to the

accounting practice of asset valuation that is lower of cost or market value. Thismay lead to understatement of trade assets to be subjected for Zakat .

AAOIFI, however, recommended the use of cash equivalent value that indicates

the value that would be realized if an asset was sold for cash in the normal course

of business as at the date of the financial statement.


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In order to ensure the reliability and comparability of the cash equivalent

value, it must be supported with objective indicators; logical and relevant

valuation methods; consistency of the use of valuation methods; expertvaluation; and conservatism in the valuation process.


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Materiality Concept:

Information is material if its omission or misstatement could influence

the economic decisions of users taken on the basis of the financial

statements. Materiality depends on the size of the item or error judged in

the particular circumstances of its omission or misstatement.

From an Islamic perspective, the nature of an item may make it material,

even if the size of the item is quantitatively insignificant. A related

Quranic verse reads: “... and if there be no more than the weight ofmustard seed, we will bring it to account ...” (Surah Al-Anbiya, verse

47).

Moreover, in fiqh, there is a legal maxim that when there is a mix of the

permissible and the prohibited, the whole becomes prohibited.


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This would appear to suggest that even small amounts of prohibited

items may be material. However, the maxim appears to be ihtiyat , a

precautionary measure rather than a ruling. There are numerous

examples of and exceptions to, the maxim.

For example, the maxim is applied in the case of a mixture of zabiha, i.e.

Islamically slaughtered, and non- zabiha meats. The mix of permissible

and prohibited meats renders the whole prohibited for Muslim

consumption. Conversely, the prohibition does not apply to a mixture ofsilk and other threads.

Although Muslim men are prohibited from wearing silk clothing, a

garment may be deemed permissible if it is made of a mixture of silk and

other threads such that the silk content does not exceed a prescribed

proportion. For financial reporting purposes, an entity may not need to

report some items below a certain threshold. Conversely, there may be

instances where an entity may be required to disclose an item regardless

of the size of the item.


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Periodicity Concept:

The conventional accounting periodicity concept is also acceptable in Islam

on the basis that even in the case of Zakat , it is being paid once a year as a

period of measurement. The concept of haul determined that the wealth

must be owned at least one year to qualify for the payment of Zakat .

Thus, the periodicity concept for an Islamic financial institution means the

life of the institution can be broken into reporting periods to preparefinancial reports to the interested parties and stakeholders.

This will assist the users to periodically evaluate the institution’s financial

performance and position. In addition, the periodic preparation of the

financial statements will be useful to determine the financial obligations andthe financial rights of the bank and other interested parties.


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Thus, the life of the Islamic bank should be broken into reporting periods

to prepare financial reports that provide information to interested parties

about the performance of the bank. One lunar year is used for Zakat calculation.


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Realization and Accrual Concepts:

AAOIFI’s SFA 2 recommends that “revenues should be recognized when

realized”. Realization of revenues shall take place when one of the threeconditions is met:

(i) the entity has the right to receive the revenue;

(ii) there is an obligation on the part of another party to remit; and

(iii) the amount of revenue should be known and collectible with

reasonable degree of certainty. Accrual basis of income recognition

does meet the requirement of Islamic objectives as it aims to measure

the ‘real’ wealth of an entity. IFIs therefore used both accrual and

cash basis of accounting.


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Documents

Accounting for IFIs